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Basel III: the regulators strike back

It’s coming on November 11-12, 2010—the last in this Basel trilogy. It will happen in Seoul, Korea, where the world’s G-20 banking regulators will gather to complete the international agreement on tough new bank rules on capital and liquidity, which they expect to be implemented by 2012.

The road to Basel III has been tumultuous. Basel I originally grouped bank assets into limited categories providing risk weightings for each. The total value of each asset was multiplied by its risk weighting, and this adjusted amount of all such assets produced a total risk-weighted asset number. For capitalization purposes, a well-capitalized bank would hold 10 percent (or, at the time, eight percent) of capital against its total risk-weighted assets (RWA).

Basel II provided four changes to the RWA calculations. First, it created many more asset categories to apply various risk weightings. Second, it placed heavy reliance on credit rating agencies to establish asset risk weightings. Third, it permitted large global banks to use their own internal risk models to determine risk weightings. And fourth, it established a different risk weighting methodology for assets that were held in trading accounts.

In the aftermath of the global recession, enter Basel III to change and refine the Basel II process. Two Consultative Documents released last December alerted banks that they should brace for the following impact: (a) higher tier 1 and tier 2 risk weighted capital ratios, driven largely but not exclusively by new concepts of a conservation buffer and a countercyclical buffer; (b) use of a leverage ratio as a indicator of strength; (c) higher risk weighting for trading assets; (d) exclusion from Tier 1 capital of items like minority interests and assets dependent on future profits; (e) enhanced capital requirements for counterparty credit risks; and (f) new short- and long-term liquidity requirements. Strong new monitoring tools, including stress tests and the enhancement and frequency of reporting and calculating the liquidity positions, also were proposed.

The December proposals were finalized to a considerable extent in an annex published on July 26. The annex mitigates certain of the December proposals; for example, minority interests, mortgage servicing rights and deferred tax assets are not completely excluded from Tier 1 capital. Some important issues remain open. A methodology for setting a countercyclical buffer—a capital addon based on total national credit versus GDP—is still unsettled. A requirement for contingent capital is another item still to be determined.

While bankers may question the efficiency and cost to bank profits connected to higher capital requirements, it is the liquidity proposals that radically alter the landscape for banks. Basel III will require banks to establish two models to ensure adequate liquidity: a 30-day model, called the “liquidity coverage ratio,” and a longer one-year liquidity process, called the “net stable funding ratio.” The liquidity coverage ratio seeks to provide assurance that banks maintain an adequate level of unencumbered, high-quality assets that can be converted to cash to meet their liquidity obligations for a 30-day period.

The net stable funding ratio would measure funding on an ongoing viable entity basis, over one year where the bank experiences events such as a significant decline in profitability; a down-grade in debt, counterparty credit or deposit rating; or an event which impacts the reputation or credit quality of the bank. The details of this ratio have yet to be finalized.

Despite industry analysis of significantly reduced profitability, lessening of access to credit and increased overhead to ensure yearend certifications on the financials may be executed, Basel III is coming, and soon. The final accord is not expected to vary widely from the public issuances currently out for comments and, once ultimately approved, will have a major impact on a bank’s credit and liquidity management processes.